Can An ETF Collapse? The Study that was proven false.

Have you ever read something that just didn’t seem correct? Recently, an article published in the Financial Times by Andrew Bogan, Ph.D, Brendan Connor and Elizabeth Bogan, Ph.D stated that Exchange Traded Funds could potentially collapse. Their thesis purports that if a situation developed where more investors are shorting an ETF than actually own the shares, there wouldn’t be enough shares left for the long investors if investors redeemed all the shares at once. They claim this would then shut down the ETF entirely and leave someone holding the bag. The article also blamed ETFs for the recent “flash crash,” which saw the Dow drop over 1000 points in a matter of a few minutes. They also argued that ETFs are misunderstood by investors. You can read the article here .

While the article has some interesting points, the ETF industry has quickly proven the thesis absolutely false. How?

Kyle Waller, research analyst at Wiser Wealth Management, Inc, states that “only properly settled shares, in good delivery, can be delivered to the Issuer for redemption.” This basically means that if you purchase an ETF and the trade has settled, then you own the underlying shares. A person simply shorting an ETF does not own settled shares. Therefore, they are taking on the additional risk.

Matt Hougan of IndexUniverse.com stated in his blog, “the [researchers] concern is addressed in the prospectus and Statement of Additional Information (SAI) of every ETF I’ve ever looked at. Here’s what it says in XRT’s [Retail ETF questioned in the article] SAI:”

“An Authorized Participant submitting a redemption request is deemed to represent to the Trust that it (or its client) (i) owns outright or has full legal authority and legal beneficial right to tender for redemption the requisite number of Shares to be redeemed and can receive the entire proceeds of the redemption, and (ii) the Shares to be redeemed have not been loaned or pledged to another party nor are they the subject of a repurchase agreement, securities lending agreement or such other arrangement which would preclude the delivery of such Shares to the Trust. The Trust reserves the right to verify these representations at its discretion, but will typically require verification with respect to a redemption request from a Fund in connection with higher levels of redemption activity and/or short interest in the Fund. If the Authorized Participant, upon receipt of a verification request, does not provide sufficient verification of its representations as determined by the Trust, the redemption request will not be considered to have been received in proper form and may be rejected by the Trust.”

Hougan goes on to say, “This means, when redeeming shares of XRT, you have to say that the shares aren’t lent out. If there’s high short interest in the fund, you’ll have to prove it, or the redemption doesn’t go through.”

Looking at the ETFs that we use here at Wiser, I agree with the assessments of Matt and Kyle. I do not see the Bogan & Connor report as having much merit for concern, especially with the ETFs that we use in our models.

What does concern me is how quickly this report showed up on CNBC without the completion of any fact checks. The report itself lacked the data to prove its points and also contained a few assumptions that are not correct. The report incorrectly assumes that investors poorly understand ETFs because they represent 70% of the canceled trades on May 6th, now known as the “flash crash.” A recent article in Barrons points the finger at Waddell and Reed, a mutual fund company, for starting the flash crash. This triggered other program trading, which resulted in a very volatile day in the market.

Not only did CNBC not do some fact checking prior to talking about the Bogan & Connor report, they also did not really portray ETFs correctly. Kyle Waller picked up on this and commented that, “CNBC called ETFs derivative products, which implies a lot of risk to the average investor. However, the plain vanilla stock ETF truly represents an un-leveraged position in a basket of stocks, deriving its value from the underlying creation unit. These kind of ETFs are derivatives the same way common stocks are derivatives of the company’s value.”

It seems to me that more people need to attend the next ETF conference. So many advisors, individuals, institutions, media outlets and, evidently, Ph.Ds do not understand this innovative product.